Businessweek Archives

Warning: A Higher Cigarette Tax May Be Hazardous To Health Financing

August 14, 1994

Economic Viewpoint

WARNING: A HIGHER CIGARETTE TAX MAY BE HAZARDOUS TO HEALTH FINANCING

Some members of Congress advocate a massive federal tax hike on cigarettes to help defray the costs of a health-care bill. The medical profession and other opponents of smoking agree on a large tax increase, though their goal is not to raise revenue but to cut down smoking. Recent research, however, indicates that a sizable cigarette tax would not generate much tax revenue, although it would cut smoking by a lot.

These findings appear in the June issue of The American Economic Review, in an article by Michael Grossman, Kevin M. Murphy, and me. In it, we estimate the response of cigarette smoking in the U.S. to changes in retail price, income level, and other variables. The research can be used to obtain reliable calculations of the effects of increases in the federal cigarette excise tax on government revenue.

These calculations assume that each 25 cents increase in the tax raises retail prices by the same amount--even though various studies indicate that prices may rise by a little more than the tax increase. Higher retail prices reduce smoking mainly by discouraging some people from beginning and by encouraging others to quit earlier than they otherwise would have, although higher prices also reduce the number of packs smoked by those who continue to smoke. Teenage smoking is especially sensitive to the cost of cigarettes.

Initially, a higher price for a pack of cigarettes does not cut smoking by a lot, since many smokers cannot quickly break the habit. But the impact is cumulative as each reduction in smoking further weakens the habit and encourages additional reductions. Indeed, our article estimates that the impact of a rise in price is about twice as large after the price has been in effect for a year: After one year, a 10% increase in price cuts smoking by about 4%, but after three years the reduction doubles to about 8%.

HOOKED POLITICIANS. The present 24 cents federal tax on a pack of cigarettes yields about $6 billion annually in federal revenue. The estimates of demand in our article imply that to reach maximum revenue in the long run would require a tax revenue of about 95 cents a pack and would raise only $6 billion annually more than the present tax. Note that somewhat larger tax revenues would be raised during the years it takes smokers to fully adjust to the higher price.

This estimate of tax revenue is much lower than that of the Congressional Budget Office because, in sharp contrast to our estimate of an 8% reduction in smoking per 10% increase in price, the CBO assumes that smoking falls at a constant rate, by about 4% for each 10% increase in the cost of a pack.

Some members of Congress are proposing a still larger increase of $1 a pack to raise the total federal tax to $1.24. That tax, in the long run, would raise only $9 billion in annual revenue--a mere $3 billion more than at present--but would cut smoking by more than 70%. Tax revenue rises and smoking falls as the total federal tax is increased to 95 cents, according to our estimates, but both smoking and tax revenue fall as the tax is made larger.

The conflict between tax revenue and consumption reduction may seriously affect government policies toward smoking. If the feds get hooked on the revenue generated by smoking taxes, Congress may hesitate to impose severe regulatory restrictions on smoking. State lotteries provide a telling warning of how this pressure works: Despite the still considerable moral and other opposition to gambling and even though lotteries are actuarially very bad bets, many states advertise extensively to the poor and others to encourage the purchase of lottery tickets.

BOOTLEGGERS'S BOOTY. Smuggling of cigarettes from neighbor nations would reduce still further the federal revenue generated by a tax hike. Canada recently was forced to reduce its draconian $2.69-per-pack cigarette tax by $1.82 because of massive smuggling from the U.S. A large U.S. tax hike would spur smuggling from Mexico and other Latin American nations with much lower taxes and would illegally divert some cigarettes meant for export to domestic use.

Cigarette taxes fall largely on the poor, since the heaviest smokers are in the lowest income and education brackets. Some smokers would be discouraged from starting if the cost of a pack rose from $1.80 to $2.80 with a $1-per-pack tax increase. But those who couldn't break the habit and continued to smoke, say, 11/2 packs a day would pay $1,533 a year in cigarette taxes, a large amount for people on welfare and those with modest incomes. It makes little sense to help finance the increased cost of the President's health plan partly with a tax that falls mainly on the poor and less educated--groups that are supposed to be helped by his health reforms.

The case for much higher cigarette taxes is very shaky in light of the regressive nature of the tax, the limited amount of revenue that would be generated, the encouragement of cross-border smuggling, and the temptation that it would pose to the federal government to encourage smoking in order to raise tax revenue.GARY S. BECKER